Buffett on M&A Valuation
I struggle a little to conceptualize in my own head the idea of one company issuing undervalued stock in order to acquire another company. I understood that a company dilutes its existing shareholders when it issues undervalued stock, but I couldn’t exactly quantify it. In this CNBC interview transcript (starting at page 17) Warren Buffett explains one way to do it in the context of Kraft’s acquisition of Cadbury, which he opposed:
- Start with the acquirer’s “headline” valuation of the deal. In this case, Kraft stated it was buying Cadbury for 13x EBITDA.
- Add to the purchase price whatever restructuring expenses the acquirer will have to pay in order to integrate the acquisition.
- Add to the purchase price whatever deal expenses (legal and investment banking fees, etc.) the acquirer will have to pay to pursue and consummate the transaction.
- Before even considering the issue of issuing stock, we can already see that Buffett thinks the “headline” purchase valuation is nonsense.
- Now the stock issuance: Take the number of shares to be issued by the acquirer as deal currency.
- Don’t multiply that number by the per-share market value of the shares. Instead, multiply it by your own estimate of the intrinsic value of the shares. That product represents the stock portion of the deal. In this case the result is to increase the purchase price of the acquisition, but when the stock of the acquiring company is overvalued, then the effect is to reduce the purchase price of an acquisition.
- In this case, the headline acquisition multiple of 13x EBITDA became, by Buffett’s estimation, a true multiple of 16-17x EBITDA.